The Fifth Circuit has finally issued its opinion in NPR (as reflected in our prior coverage, this case was argued almost two years ago), a case involving a Son-of-BOSS tax shelter in which the district court absolved the taxpayers of penalties. The taxpayers were not as fortunate on appeal, as the Fifth Circuit handed the government a complete victory.

The court’s consideration of the two issues before the court of broadest applicability were overtaken by events — specifically, the Supreme Court’s December 2013 decision in United States v. Woods. See our report here. In line with that decision, the NPR court held that the penalty issue could be determined at the partnership level and that the 40% penalty was applicable because the economic substance holding meant that the basis in the partnership was overstated. This latter holding reversed the district court, which had relied on the Fifth Circuit precedents that were rejected in Woods.

The other issues resolved by the Court were mostly of lesser precedential value. First, the court affirmed the district court’s conclusion that a second FPAA issued by the IRS was valid because NPR had made a “misrepresentation of a material fact” on its partnership return.

Second, the court rejected the district court’s holding that the taxpayers could avoid penalties on the ground that there was “substantial authority” for their position. It criticized the district court for basing its “substantial authority” finding in part on the existence of a favorable tax opinion from a law firm (authored by R.J. Ruble who eventually went to prison as a result of his activities in promoting tax shelters). The court explained that a legal opinion cannot provide “substantial authority”; that can be found only in the legal authorities cited in the opinion. Here, the legal opinion had relied on the “Helmer line of cases,” which establish that contingent obligations generally do not effect a change in a partner’s basis. The court of appeals held that Helmer did not constitute substantial authority in a situation in which the transactions lack economic substance and in which the partnership lacked a profit motive. The court also observed that the IRS was correct in arguing that its Notice 2000-44 should be considered as adverse “authority” for purposes of the “substantial authority” analysis — albeit entitled to less weight than a statute or regulation.

Finally, the court overturned the district court’s finding that the taxpayers had demonstrated “reasonable cause” for the underpayment of tax. With respect to the partnership, the court stated flatly that “the evidence is conclusive that NPR did not have reasonable cause.” With respect to the individual partners, the court left a glimmer of hope, ruling that an individual partner’s reasonable cause can be determined only in a partner-level proceeding. Thus, the court merely vacated the district court’s finding of reasonable cause and left the individual partners the option of raising their own individual reasonable cause defenses (whatever those might be) in a partner-level proceeding.

The taxpayer filed its opening brief in the Fifth Circuit appeal of BMC Software v. Commissioner. As we described in our earlier coverage, the Tax Court relied on the legal fiction that accounts receivable created pursuant to Rev. Proc. 99-32 in a 2007 closing agreement were indebtedness for earlier years (2004-06) in order to deny some of the taxpayer’s section 965 deductions. There are three main avenues of attack in the taxpayer’s brief.

First, the taxpayer argues that the Tax Court incorrectly treated those accounts receivable as “indebtedness” as that term is used in the exception to section 965 for related-party indebtedness created during the testing period. The taxpayer contends that the Tax Court looked to the Black’s Law definition of “indebtedness” when it should have looked to the tax law definition. And the taxpayer argues that the tax law definition—that “indebtedness” requires “an existing unconditional and legally enforceable obligation to pay”—does not include the fictional accounts receivable created under Rev. Proc. 99-32. The taxpayer argues that those accounts did not exist and were not legally enforceable until 2007 (after the section 965 testing period) and therefore did not constitute related-party indebtedness during the testing period for purposes of section 965.

Second, the taxpayer argues that the Tax Court was wrong to interpret the 2007 closing agreement to constitute an implicit agreement that the accounts receivable were retroactive debt for purposes of section 965. The taxpayer observes that closing agreements are strictly construed to bind the parties to only the expressly agreed terms. And the taxpayer argues that the parties did not expressly agree to treat the accounts receivable as retroactive debt for section 965 purposes. Moreover, the taxpayer argues that the Tax Court misinterpreted the express language in the agreement providing that the taxpayer’s payment of the accounts receivable “will be free of the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustments.” The taxpayer then makes several other arguments based on the closing agreement.

Finally, the taxpayer makes some policy-based arguments. In one of these arguments, the taxpayer contends that the Tax Court’s decision is contrary to the purpose of section 965 and the related-party-indebtedness exception because the closing agreement postdated the testing period and therefore cannot be the sort of abuse that the related-party-indebtedness exception was meant to address.

That didn’t take long. Less than two weeks after learning that the parties would not be mediating their dispute (see our previous report here), the Ninth Circuit issued a brief five-page unpublished opinion affirming the Bergmann casein favor of the government. The court held that the time for filing a qualified amended return for an undisclosed listed transaction terminates when the promoter (here, KPMG) is first contacted by the IRS about examining the transaction, not when the IRS later determines the transaction is a tax shelter.

To recap the issue (see our original report here), under Treas. Reg. § 1.6664-2(c)(3)(ii), as in effect when the Bergmanns filed their amended return, the time to file a qualified amended return terminates when the IRS first contacts a “person” concerning liability under 26 U.S.C. § 6700 (a promoter investigation) for an activity with respect to which the taxpayer claimed a tax benefit. The Bergmanns claimed tax benefits from a Short Option Strategy promoted by KPMG on their 2001 tax return. The IRS served summonses on KPMG in March 2002 for its role in promoting the Short Option Strategy transactions. The Bergmanns did not file their qualified amended return until March 2004, shortly after KPMG identified the Bergmanns as among those taxpayers who participated in the transaction. The Bergmanns argued that “person” as used in the regulation meant only those persons liable for a promoter penalty under 26 U.S.C. § 6700.

The Ninth Circuit quickly dispatched the taxpayers’ argument, characterizing their interpretation of the regulation as “impermissibly rendering its text and purpose nonsensical.” Under the express language of the regulation, it applies when the promoter is “first contacted,” not found liable. The court of appeals concluded by observing that the purpose of qualified amended returns is to encourage and reward taxpayers who “voluntarily disclose abusive tax practices, thereby saving IRS resources.” Here, the taxpayers did not amend their return until after KPMG gave their names to the IRS.

The Supreme Court heard oral argument on January 14 in Quality Stores. Whether it was because of a lack of interest in the subject matter or because it was the third argument of the day at the unusually late hour of 1:00 (the Court’s usual schedule in recent years calls for two (sometimes only one) arguments in the morning that finish before lunch), the Court was less active than usual in its questioning. Indeed, the government’s counsel began to sit down after using only five of his allotted 30 minutes for his opening argument (though he was then persuaded to remain at the podium by some additional questions). By the end, all of the Justices except Justice Thomas participated, and the advocates for each side had to deal with some hostile questions. The questioning was not so one-sided as to make the outcome a foregone conclusion, but the Court seemed to be leaning more towards the government’s position than the taxpayer’s. On the other hand, the Court seemed to be learning some of the nuances of the case as the argument proceeded, so there is the possibility that the views of some Justices could yet shift from where they appeared to be at oral argument.

Eric Feigin began the argument for the government, and he was allowed to make his basic presentation without interruption – namely, that the severance pay here comes within the broad definition of FICA wages and the Court should not have to worry about the text of section 3402(o), the income tax withholding statute on which the taxpayer relies. On the latter point, Justice Ginsburg interrupted to ask about the statement in Rowan indicating that wages should be interpreted the same way for FICA and income tax withholding. Mr. Feigin gave two responses: 1) Rowan does not say that the income tax statute should govern the substance of the FICA statute; and 2) the basic principle of Rowan is to establish congruence between FICA “wages” and income tax withholding “wages” for purposes of administrability, and that goal would be advanced by adopting the government’s position.

After Mr. Feigin described the background of the 1969 income tax withholding legislation, Justice Kennedy asked about the history of FICA withholding of supplemental unemployment benefits. Mr. Feigin responded that there is no FICA withholding of SUB payments, apparently referring to the government’s narrow definition of SUB payments that the revenue rulings exempt from FICA wages, rather than the broader concept of SUB payments as defined in section 3402(o). The Chief Justice then asked him to clarify the reason for the enactment of section 3402(o), and Mr. Feigin explained that the benefits were considered to be taxable income even if not subject to withholding. At that point, Mr. Feigin stated that he was prepared to sit down unless there were further questions. That suggestion proved to be premature, as it turned out that there were several Justices who still had questions.

Justice Ginsburg began by asking about the effect on state unemployment compensation. That question arises from the fact that some states will not pay unemployment compensation if the employee is receiving “wages,” even if the employee is out of work. To avoid having individuals in those states lose their state unemployment benefits as a result of receiving SUB payments from their employer, the IRS has drawn a strange distinction in its revenue rulings, currently providing that SUB payments must be “linked to state unemployment compensation in order to be excluded from the definition” of FICA wages. Rev. Rul. 90-72. That distinction is policy-driven, but makes no logical sense as an interpretation of the statutory text. Mr. Feigin sought at first to steer away from this problem by saying that the government was arguing for the status quo, so nothing would change. He added, however, that “if the court were to reach some other conclusion in this case than the one the government is urging” (which appears to be a reference to the possibility that the Court’s decision would wipe out the distinction in the revenue ruling), then that might have an effect on state unemployment benefits. The states, he argued, could then cure any problems by amending state law.

After a short response to Justice Kennedy’s question about whether some employees might prefer to have these payments treated as FICA wages, Mr. Feigin again began to sit down. This time Justice Alito asked whether it would make a difference if the payments were not keyed to length of service. Mr. Feigin responded that the government’s position would be the same. Justice Alito then followed up by citing the Coffy case and asking why the distinction drawn there “between compensation for services and payments that are contingent on the employee’s being thrown out of work” was not applicable. Mr. Feigin replied that the cases involved different issues and different definitions. He went on to argue that FICA does not distinguish “between payments that are part of the continuing employment and payments that occur at the end of the employment relationship,” stating that FICA wages include retirement pay and dismissal payments. At that point, Mr. Feigin again offered to end his presentation and was permitted to sit down after 12 minutes of argument.

Robert Hertzberg argued for the taxpayer and began by arguing that the SUB payments were not “remuneration for services” – and hence not FICA wages – because, as stated in Coffy, they were contingent on losing one’s job. Justice Sotomayor asked the first question, inquiring whether the taxpayer could prevail if the Court invalidated the government’s “regulation” (likely a reference to the applicable IRS revenue rulings). This question appears to have been prompted by the heavy criticism of the IRS rulings, particularly in the amicus briefs, with Justice Sotomayor wanting to put aside the rulings and focus on the statute. Mr. Hertzberg replied that the taxpayer should prevail because the statutory language is clear, and the FICA and income tax withholding statutes should have the same meaning under Rowan. Both Justices Sotomayor and Ginsburg then suggested that it would be simpler and more appropriate to have the SUB payments treated the same way under the two statutes. Mr. Hertzberg replied that they were not “wages” under the statute. He added that different treatment made sense because the SUB payments are provided as a “safety net” and logically ought not to be reduced by FICA taxation in order to fund Medicare and Social Security.

Justice Scalia pointed out that the payments are “for faithful and good past services” because they are paid only to employees, and this comment led to a bevy of questions from all sides. Justice Ginsburg remarked that there “are some severance payments that do count for FICA purposes,” even under the taxpayer’s position. Justice Alito asked what would happen if section 3402(o) did not exist. Mr. Hertzberg replied that the term “supplemental unemployment benefits” has its own definition, going back to 1960 legislation dealing with trusts, and those benefits have not been regarded as FICA wages, even in the 1977 revenue ruling. He then emphasized that Congress reenacted the FICA statute in 1986 against that backdrop, and therefore that payments falling within the existing definition of SUB payments should not be within FICA wages.

Justice Breyer then objected that the FICA definition is very broad. With respect to income tax withholding, he questioned whether section 3402(o) shouldn’t be viewed as just being enacted to be on the safe side, but not necessarily indicating that Congress had concluded that SUB payments were not FICA wages. Mr. Hertzberg responded that it was clear from the text, the title of the section, and the legislative history that Congress did not understand SUB payments to fall within FICA wages. This triggered Justice Ginsburg to ask again what is the distinction between “dismissal payments” that are subject to FICA and those that are not. After Mr. Hertzberg described that distinction (that SUB payments must come from a plan and follow a mass layoff or plant closing), Justice Breyer came back to his question. Acknowledging now that Congress in 1969 probably did not view the SUB payments as FICA wages when it passed section 3402(o), he asked why that should be given weight in construing the FICA statute passed earlier by a different Congress. Mr. Hertzberg replied that the statutes were reenacted together in 1986, and therefore it was not just a matter of a later Congress commenting on what an earlier Congress had passed. Justice Breyer’s followup comment, however, indicated that he either did not understand or was not persuaded by this answer, as he noted that the statute was passed because there was “authority saying it wasn’t wages,” but the authority was not necessarily correct.

Justice Alito then asked about the government’s argument that the “treated as” language in section 3402(o) was necessary because the IRS had ruled that some SUB payments are not wages, but it did not mean that all such payments were not wages. Mr. Hertzberg replied that the language of 3402(o) was clear, particularly the title, which addresses payments “other than wages.” The argument closed with Justice Scalia promising to ask the government on rebuttal about Mr. Hertzberg’s point that, given the reenactment of both statutes at the same time, it appeared that section 3402(o) is superfluous under the government’s position.

Mr. Feigin begin his rebuttal by addressing Justice Sotomayor’s question about how the Court should approach the case if the IRS revenue rulings are invalid. He said that this would not affect the outcome of this case because the defect in the rulings would be that they exclude some SUB payments from wages, when in fact all such payments should be included. That is, any problem would be cured by making even more SUB payments subject to FICA taxation. Justice Sotomayor replied that this answer was “touching at what I was thinking,” and then asked Mr. Feigin to address Justice Scalia’s point about 3402(o) being superfluous. Mr. Feigin began by acknowledging that “the revenue rulings are not consistent with the statutory text of FICA.” He attributed this defect to the fact that the rulings trace back to a “more freewheeling time in the history of statutory interpretation.”

Justice Scalia then jumped in to bring the discussion back to whether section 3402(o) was unnecessary, stating that the statute “contradicted itself” if the government’s position were correct. Mr. Feigin responded by making the same point that Justice Alito had made earlier (also reflected in the Federal Circuit’s CSX decision) that there was no contradiction if section 3402(o) was drafted as it was because there were some SUB payments that were not wages under the revenue ruling. Justice Scalia found that response unsatisfying since the title clearly refers to payments “other than wages.” Mr. Feigin answered by saying that the title refers to “certain payments” and the statute provides that they should be “treated as wages for a payroll period.” He then went on to reiterate his prior points about the history of the development of section 3402(o) and argued that it was drafted as it was to cover the possibility that the IRS would draw different distinctions in the future regarding which SUB payments constitute “wages.”

Finally, this discussion prompted Justice Ginsburg and Chief Justice Roberts to revisit the IRS revenue rulings, which the Chief Justice characterized as taking a narrower view of the FICA definition than the government was arguing for. Mr. Feigin responded that the rulings were not directly at issue here, but if the Court thought it had to rule on them, it should follow the government’s current arguments regarding the statutory text “notwithstanding the revenue rulings.” He then again assured Justice Ginsburg that the states could fix any bad results related to their own unemployment compensation schemes that might ensue from invalidating the revenue rulings.

It is always tricky to forecast a Supreme Court decision based on the oral argument. Still, it cannot have been encouraging for the taxpayer that its counsel was the recipient of most of the difficult questioning, with Justices Sotomayor and Breyer in particular seeming to exhibit agreement with the government’s position. On the other hand, as noted above, the Court appeared still to be digesting some of the complexities of this case, so the positions reflected at oral argument are not set in stone. For example, Justice Scalia showed more skepticism of the government’s position during rebuttal than he did during Mr. Feigin’s opening argument. Time will tell. A decision is expected this spring, likely issuing sometime between late March and early June. If the vote on the Court is 4-4, however (with Justice Kagan being recused), then the Court will announce that outcome as early as next week. That is because there will be no need to write an opinion; the result will just be a one-line announcement that the decision has been affirmed by an equally divided Court.

A court can lead the parties to mediation, but can’t make them drink. We reported last month that, after oral argument, the Ninth Circuit had suspended its consideration of the Bergmann case so that the parties could pursue court-sponsored mediation. Apparently, that effort never got off the ground. Yesterday, the Ninth Circuit entered a new order: “We previously withdrew submission pending an opportunity for mediation. Because mediation has not resolved this appeal, the case is ordered resubmitted as of the date of this order.” The Court will now proceed to write an opinion and issue its decision in due course. When that happens, one of the parties likely will be sorry that it wasn’t more flexible with the mediation process and the other will feel vindicated.

The government’s reply brief has now been filed in Quality Stores, completing the briefing. The Court will hear oral argument on January 14.

Also linked below are three amicus briefs that have been filed in support of the taxpayer. The brief filed by the ERISA Industry Committee comprehensively addresses the question presented, examining the relevant statutes, legislative history, administrative pronouncements, and judicial precedents. The brief filed by the American Payroll Association engages in a statutory analysis and examines the administrative pronouncements, concluding that the government’s position “would replace the straightforward definition provided by Congress with a cumbersome and essentially unadministrable definition.” The brief filed by the American Benefits Council focuses almost exclusively on the IRS’s Revenue Rulings. Admittedly “derived from an article” previously published by the brief’s author, the amicus brief argues that the regime established by the Revenue Rulings is “incoherent and unsupported” and should be rejected by the Court in favor of the taxpayer’s position, which is “coherent, sensible, and easily understood.”

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Miller & Chevalier was founded in 1920 as the first federal tax practice in the United States. For nearly 95 years, the firm has successfully represented the most sophisticated corporate clients in all facets of federal income taxation. Miller & Chevalier’s Tax department serves clients headquartered throughout the U.S. and around the world and, over the past several years, has represented approximately 30 percent of the Fortune 100 and more than 20 percent of the Global 100. Our clients come to us to solve the thorniest of tax issues, and we have litigated many of the most significant tax cases on record.

The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.